Sovereign Yield Spreads During the Euro Crisis: Fundamental Factors Versus Redenomination Risk

The intensity of the euro crisis has been reflected in significant increases in sovereign bond yields in the most troubled countries. This has triggered a debate over whether this increase can be attributed solely to fundamental factors or whether part of the increase represents redenomination risk that one or more countries will drop out of the European Monetary Union and reintroduce their own national currencies. Using a novel market-based indicator from the virtual prediction market Intrade, this paper explores whether such systemic risk is present in the yield spreads of nine euro-area countries. We find that redenomination risk has played a role in the determination of sovereign yields, and that this risk is related to the expected valuations of newly introduced currencies: those of Portugal, Ireland, Spain and Italy are expected to depreciate, while newly introduced currencies of other countries are expected to appreciate following a break-up of the EMU. "Risk premia that are related to fears of the reversibility of the Euro are unacceptable, and they need to be addressed in a fundamental manner." (ECB President Mario Draghi, August 2012)